Research Note: ECB Interest Rate Decision

Summary Outlook: On Thursday, January 12 at 0745ET/1245GMT the ECB is expected to hold rates steady at 1.00%, according to Bloomberg surveys. However, we think there is a slightly less than even chance they cut rates by a further 25 bps to 0.75%, a record low for the benchmark refinance rate. If they do, markets are likely to react quite negatively on the EUR, both on the surprise factor and on the view that the ECB is more concerned about the outlook than previously thought and would likely cut rates further still. If they hold steady, the EUR may see a short-term recovery higher, as those who sold on the prospects of a cut are forced to cover. Either way, the 0830ET/1330GMT ECB press briefing is likely to emphasize the downside risks to the economic outlook and that inflation pressures continue to recede, leaving a distinctly dovish impression. In the Q&A, we expect Draghi to be queried on whether the ECB has any plans to increase the amounts of its government bond purchases in light of recent weakness in Italian and Spanish bonds. We think he is likely to stick with the prior stance that the SMP (Securities Market Program) will remain limited in scope and duration, which would weigh on the single currency in our view. Should he indicate a stepped up SMP, we think the EUR could benefit significantly, as it would indicate a major shift by the ECB to support sovereign debt markets.

Other key events tomorrow are the 0700ET/1200GMT Bank of England rate decision, which we expect will be steady (consensus) and typically no statement is released when policy is unchanged. (The risk with the BOE would be an announcement of an increased Asset Purchase Program target, but we think it’s too soon and thus minimal.) Also, Italy will auction EUR 12 bio of short-dated government bills and the results of the auction will be important for EUR; results should be known shortly after 0500ET/1000GMT. Lastly, 0830ET/1330GMT US December retail sales will be an important data point for the US recovery and the prospects for QE3.

Market Strategy: EUR remains under pressure across the board ahead of the ECB decision, but has essentially established a 1.2650-1.2830 consolidation range so far this week. Should the ECB cut rates, we think the lower end of the range will be tested at the minimum, but we would note the 1.2600/10 area is also critical support (76.4% retracement of 1.1877-1.4942 advance). If that lower level breaks, we would ultimately expect a 100% retracement to unfold in the months ahead, but for the short-term we would target immediate potential lower to the 1.2450/70 hourly channel base, with 1.2500 likely providing some psychological/option related support along the way. If the ECB holds steady, EUR/USD may see a bounce as shorts are squeezed, but we think this would be temporary and likely reverse on a dovish ECB press conference. Ideally, we would look to fade strength (i.e. establish short EUR/USD) in the 1.2830/80 area, keeping a stop relatively tight at 1.2930, just above the 61.8% retracement of the most recent 1.3070-1.2660 decline. (Depending where EUR/USD is ahead of the ECB announcement (last ca. 1.2700), we may have to be content with a lower entry point, possibly 1.2740/80.) Given the preponderance of short-EUR positioning, we would prefer to use 40-50 point trailing stops on short positions to guard against intra-day short squeezes.